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Taxation

Commentary: Tax Reform and the Implications for State and Local Bonds

It would be tempting to simply ignore the current discussion of tax reform. Generally, the proposals call for large rate reductions, with the cost of the rate reductions being offset by repeals or limitations of unspecified tax expenditures.

The offsetting revenue increases pose difficult political choices because the math is clear: there are not enough special-interest benefits to finance a significant rate reduction.

Those political choices are not even acknowledged today because of their potential unpopularity. There is no reason to believe that the choices become easier after the election.

Notwithstanding the uncertain prospects for tax reform, I do not believe that the tax-exempt bond community has the luxury of ignoring the debate. The tax exemption has the dubious distinction of being one of two items actually identified as a target in tax reform.

Whether part of tax reform or the inevitable deficit-reduction deal, we may be witnessing the most serious challenge to the tax exemption since the Roosevelt Administration recommended repeal as a war-time revenue increase. In order to prepare a response, proponents of the exemption need to understand why this revenue increase may be favored over others.

In any tax reform involving large rate reductions, there will be a desperate attempt to find tax increases that impact upper-income taxpayers in order to prevent a regressive shift of tax burden.

A similar dynamic would be present in a deficit-reduction deal. Repeal of tax exemption is perfect for that purpose. It will be shown as a tax increase on upper income investors even though much of the actual burden of the change will be borne by others.

An accurate measure of the burden on investors from repeal of the exemption would involve taking into account the implicit tax that the investor currently pays by accepting the lower tax-exempt yield.

However, under all current methods, all of the revenue from a repeal of the exemption would be assigned to the upper-income investor even though state and local governments will bear most of the loss. The portion of the loss borne by state and local governments could actually be a regressive tax increase because many states have regressive tax structures.

The main economic argument for repeal of the exemption is the suggestion that it could increase economic growth by permitting a more efficient allocation of resources in the economy.

Implicit in that argument is the assumption that tax-exempt bonds have resulted in over-investment in public infrastructure and the economy would benefit by reducing that public investment.

Given the inadequate state of public infrastructure and the resulting costs imposed on our economy, this is an argument that proponents of the exemption can win.

The other main argument for repeal of the exemption is that it is an inefficient way of subsidizing state and local governments. This argument is correct but it is merely a diversion from the actual goal of shifting resources from the public to the private sector. However, there is a readily available policy response, one that proponents of the exemption should embrace: reinstate the Build America Bond direct payment option.

Finally, the tax-exempt bond community needs to analyze the broad implications of tax reform on the ability of state and local governments to finance their operations and service their debts.

Repeal of the deduction for state and local taxes is a form of negative revenue sharing - it will increase the effective rate of state and local taxes with all of the resulting revenue going to the federal government.

There is little doubt that repeal of housing tax benefits would lead to further reductions in housing prices, threatening real property tax revenues. In short, it is time to be engaged in the debate.

John Buckley is a professor in the graduate tax program at
the Georgetown University Law Center and formerly was
chief Democratic tax counsel for the House Ways and Means Committee.
He has spent nearly four decades on the Hill participating
in the development of federal tax legislation.


 

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